Martin Hutchinson (Money Morning):

U.S. Federal Reserve Chairman Ben Bernanke’s latest thesis is that the home mortgage bubble had little to do with record low interest rates, and was actually much more a problem of regulation.

It sounds plausible – until you give it some real thought. After all, I believe that humanity has already tried a system with tight, vigorously enforced regulations, and no price mechanism.

It was called the Soviet Union.

Okay, that was a bit of a cheap shot – to some extent. Bernanke stated that “borrowers chose and were extended mortgages that they could not be expected to service over the longer term.” That appears to make the problem one of regulation: The types of mortgages that banks should be permitted to offer should be limited to ones that borrowers have a reasonable chance of servicing.

In theory this makes sense. However, it is a prime example of what I in the past have referred to as the “Keynesian Bureaucrat Fallacy,” or KBF.

Under the KBF, wise bureaucrats – who, like economist John Maynard Keynes, were presumably educated at Cambridge and steeped in the traditions of the Bloomsbury Group – will decide the appropriate regulations for every sphere of the economy.

They will then enforce them with draconian rigor, forcing the economy to behave in a way that optimizes economic welfare, measured by whatever means the bureaucrats devise. Irrational market-based signals – such as the price mechanism, will be ignored – unless the bureaucrats decide it is safe to take account of them.  . .

Click here for the rest of Mr. Hutchinson’s commentary on Money Morning.

I call them the “zombies,” the institutions being propped up by government bailouts. Companies like Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), General Motors Corp., Chrysler LLC, etc. On an operating level, these walking dead are sucking the life out of the recovery.

Unlike in previous downturns, huge resources have been devoted to propping up entities that should have been taken out of the picture.

Of course, it’s easy to avoid zombies directly. No one is going to force you to take a position in GM. But if you really want to know where to look for the bargains – for companies that have the greatest potential for serious growth in real numbers and real markets – you need to look for what I call “zombie-free zones.”

Unfortunately, the United States and the United Kingdom are not “zombie-free” zones – and thus offer the worst hunting ground available right now.

If you’re looking for something solid, there are only three places to aim your portfolio. In fact, my top three picks are…

Germany, Korea, and Canada.  All have an abundance of companies you can invest in with at least a good chance of not being forced to compete with the undead.

The Problem with Zombies

You see, the problem with zombie banks and companies is that they soak up resources that should be devoted to living banks and companies, while providing unfair competition that makes their competitors unsound.

It’s difficult to see this effect at the moment, because the U.S. Federal Reserve is propping up the banking sector. It’s much clearer in the automobile sector, where the zombies GM and Chrysler make it more difficult for Ford Motor Co. (NYSE: F) to compete. There’s no question that the continued existence of Chrysler after its first non-bankruptcy in 1979 drastically weakened Ford in the 1980s and 1990s.

There’s the effect on wages too. The United Auto Workers (UAW) union is a huge supporter of the GM and Chrysler rescues, partly because they keep UAW members employed at above-market wage rates. One certainly can sympathize with the great many American autoworkers that have lost their jobs, but by keeping the sector over-employed, the government is driving up wages and hurting businesses – particularly Ford, the only member of Detroit’s “Big Three” to not ask for a bailout.

The same effect can be seen in the banking sector. The bonus pool at JPMorgan Chase & Co. (NYSE: JPM) is partly inflated by the continued employment of all the Citibankers who should have lost their jobs. Since banking pay scales got over-inflated during the bubble, it is reasonable now for them to come back down to earth, but that’s not going to happen while banks are in their current undead state.

Turning to the international market, it is immediately clear that Britain has the same problem as the United States, only on a larger scale. Royal Bank of Scotland Group PLC (NYSE ADR: RBS) and Lloyds Banking Group PLC (NYSE: LYG), two of Britain’s largest banks have been kept open by the government. (Though, to be fair, Lloyds only got in trouble because the government made it acquire another failing bank, HBOS.)

Financial services is a huge part of Britain’s economy, which needs to diversify, but it won’t be able to diversify if so much of its talent is locked up in banking, and its best graduates are sucked into the high-paying dealing rooms of the City of London.

Japan has the same problem. Here the zombies are really ancient, cobwebbed skeletons left over from the 1990 collapse of Japan’s bubble. Some of them were put out of their misery by Junichiro Koizumi, the reformist prime minister, in 2003. Yet just this week we learned that many Japanese retailers face losses because of competition from The Daiei Inc. and Ito-Yokado Co. Ltd., gigantic retailing companies that were effectively bankrupt in 1993 but have been propped up by Japan’s banks. If you’re afraid of zombies, Japan is really creepy!

Historically, Europe is the continent where investors have suffered most from zombies propped up by governments. Certainly some countries, notably Italy, are attractive only for investment necrophiliacs.

Where to Find “Zombie-Free Zones”

There are some exceptions. Germany has only a few relatively small zombies. Both Sachsen LB and IKB Deutsche Industriebank AG, the banks that got in trouble buying U.S. subprime mortgage-backed bonds, have been sold to other buyers – Sachsen to a larger Landesbank and IKB to the private equity group Lone Star Funds. Whatever their subsequent fate, those banks are currently being managed on a profit-maximizing basis.

There is a large older zombie, Hypo Real Estate Holding AG, the former Bayerische Hypothekenbank, which got in trouble in the late 1990s lending to real estate in the former East Germany, but that appears an isolated example. Industrially, Germany has been admirably rigorous in cleaning up its dead companies, and with its new pro-market government looks attractive for zombie-fearing money.

In Asia, South Korea is probably your best bet. The country had a big zombie problem ten years ago, but that problem has been cleared up with the bankruptcy and reorganization of several conglomerates and much of the banking system. This time around, there have been few major casualties and so the economy looks relatively zombie-free.

Finally, there is our northern neighbor, Canada. Canadian housing never became as over-extended as U.S. housing, and the Canadian bank bailout was correspondingly smaller, with none of the banks facing bankruptcy. Canada had a bad zombie problem fifteen years ago from decaying heavy industry, but today those zombies are long gone and the Canadian economy is resilient. The most recent bankruptcy, Nortel Networks Corp. (OTC: NRTLQ) in Jan. 2009, is being handled in a thoroughly market-oriented fashion, with its assets being sold off piecemeal. So your money is safe in Canada – lots of snow, but no zombies!

Source: Why You Need to Look at these Three ‘Zombie-Free Zones’

U.S. Federal Reserve Chairman Ben S. Bernanke and Congress agreed Friday that the financial system – not the American taxpayer – should bear the costs of bank bailouts. Sheila Bair, head of the Federal Deposit Insurance Corp. (FDIC), wants the banks to ante up $45 billion – three years’ worth of deposit-insurance premiums – to bail out the fund that insures bank deposits.

When it comes to bank stocks, we all know that there were a number of Money Morning readers shrewd enough to buy Citigroup Inc. (NYSE: C) shares when the foundering giant’s stock price was below $1 a share.

If you’re one of those investors, good for you: With Citi’s shares now trading at nearly $4.70 a share, that shrewdness – or courage – has been amply rewarded.

But the question we have to ask at this point is: Why would anyone buy banks stocks right now?

Bailouts Revisited

When the Bush administration bailed out the banks last autumn, I opposed the bailout. But I understood the rationale for it. The Lehman Brothers Holdings Inc. (OTC: LEHMQ) bankruptcy had clearly done a lot of damage to market confidence. Thus, a series of high-profile failures – however well merited – could push the market into a behavioral funk that might take years to emerge from.

After all, as we were incessantly reminded, the banks were all intimately inter-connected – not in the least by the diabolical credit-default-swap market. So a big failure could trigger a mass-market meltdown.

That justified the immediate bailout back then. But it did not justify the continued existence of those banks and other financial institutions – especially Citi, Bank of America Corp. (NYSE: BAC) and insurance giant American International Group Inc. (NYSE: AIG) – a year after the bailout.

Even if there was an argument for preventing the immediate meltdown of those companies – to prevent panic – there was no good argument for allowing them to continue in business as zombies, distorting the market forever after. An orderly liquidation was what was really needed.

But if the plans called for these three bad actors to be liquidated, it should surely be happening by now. Two of the three have even kept their top management for the intervening year. The exception has been BofA, where Chief Executive Officer Ken Lewis is now being shoved – kicking and screaming – toward the exit. (However, I have no doubt he’ll end up being well rewarded for the indignity).

Japan’s ‘Lost Decade’

Economically, keeping banks and other companies alive after they should be dead is the mistake Japan made back in the 1990s. After Japan’s massive stock market meltdown, most of the banks were technically insolvent. A decline in the value of the stocks the banks held had gnawed away their capital, while their assets were shredded by the collapse in the value of their real-estate loans.

Despite this, Japan opted to prop up many insolvent companies, which kept the country’s entire banking system on life support until 1998 – hence the “Lost Decade” of financial legend. And a true resolution of the problem did not come until it was forced by Prime Minister Junichiro Koizumi in 2003. The result was more than a decade of economic stagnation and a mountain of public debt that actually exceeded 200% of gross domestic product (GDP).

For the banks themselves, the fallout can be even worse.

An ‘Artificial’ Market

At first blush, the profits of the last few months look pretty good. And the record bonuses being threatened on Wall Street suggest that all is fine. However, there are two problems. First, bank earnings have been propped up by an extraordinarily bank-friendly monetary policy, keeping short-term interest rates at close to zero and buying up more than $1.5 trillion of bad bank loans from the markets.

That simply can’t last. If it does, we’ll end up with a bad case of hyperinflation.

As for the bonuses, does anybody think that if Citi had gone bust, and ex-Citibankers were now selling apples on the street corners of New York, bonuses would be zooming so high?

If the market for overpaid bankers had been allowed to clear properly, they would no longer be overpaid.

If the Japan’s Nomura Securities (NYSE ADR: NMR) wanted to double its U.S. staff, as it announced Monday (an extraordinarily shareholder-hostile decision, given Nomura’s lousy U.S. track record), it could just lean out of its office and whistle, and a parade of ex-Citibankers, ex-AIG executives and ex-BofA execs would rush in, begging for scraps.

It appears that the concerns that Soros expressed are well justified.

A Grim Reaping For Bank Investors

Since there are more competitors in the market than there should be, once the Fed’s over-generous monetary policy is corrected, there will be too much competition, so bank profits will be squeezed. Conversely, there will be too many jobs in the industry, so banker pay scales will be artificially propped up.

If that’s a recipe for good shareholder returns, I’m a Dutchman.

There’s more. The populist fury against the banking system doesn’t look like it’s doing much about banker pay. However, it will almost certainly result in special extra taxes being levied on surviving banks, to pay for the bailouts.

The costs of those taxes will be passed through to shareholders, because competition from all the zombies that are still in business will prevent banker pay from being squeezed much. The extra levies that Bair, the FDIC chief, is employing to keep the deposit-insurance fund solvent also will fall on banks, although in this case it will be the small and medium-sized that will suffer the worst.

Squeezed profits, expensive staff, extra taxes and special FDIC levies – it doesn’t look to me as if there will be much left for bank shareholders.

Expect 2010 to be a grim year for them.

Source: Hidden Traps Make Bank Stocks a Bad Deal

Now, JPMorgan Chase & Co.  (NYSE: JPM) has issued a report suggesting that investment-banking returns on capital will be sharply down over the next few years. Perhaps this will be only a moderate downturn.

However, there’s also a good chance that labor-cost pressures – combined with tightening margins – will take the likes of JPMorgan and Goldman Sachs Group Inc. (NYSE: GS) down a path similar to that of General Motors Corp. (NYSE: GRM) and Chrysler Group LLP, both of which earlier this year declared bankruptcy.

Challenging Headwinds

JPMorgan anticipates that the regulatory changes that are likely to take place over the next year or so will reduce investment banks’ return on equity (ROE) to around 11% – down from its previous forecast of 15%.

More capital will be needed for trading activity, which naturally reduces the return on capital from that activity. However, there will also be effects from new transparency requirements on derivatives. (Most – if not all – derivatives will have to be traded and cleared across central exchanges.) And tighter limits on commodities positions will prevent firms from cornering less-active markets.

This effect will be concentrated on investment banks themselves – firms such as Goldman Sachs and Morgan Stanley (NYSE: MS) – as well as on the investment banking activities of such firms as Credit Suisse Group AG (NYSE: CS), Deutsche Bank AG (NYSE: DB), Citigroup Inc. (NYSE: C), and JPMorgan Chase.

Old-fashioned commercial banking, on the other hand, will likely become somewhat more profitable. That’s because the sharp reduction in securitization activity has reduced the excessive competition for much of the lending business. It’s also improved the lending business profitability.

Investment banks will have to reduce their headcount by another 3% from present levels and cut their overall cost per employee by another 15%, to around $543,000 in 2011, according to the JPMorgan study.

What agony! (Actually, that joke is not quite fair – the cost per employee includes the building, the equipment and all the fancy information services, so the take-home is much less. Even so, these guys – at least those who keep their jobs – won’t starve.)

The New Reality

We are so used to investment banking growing and becoming increasingly more profitable – on virtually an uninterrupted basis – that we have never even considered what might happen if that trend were to reverse.

Even after last year’s crash, Goldman Sachs reported record second quarter profits in 2009. Spreads in all kinds of trading widened dramatically and Goldman found its market share dramatically increased after the demise of Lehman Brothers Holdings Inc. (OTC: LEHMQ).

But here’s the thing: The trillions of dollars poured into the markets by the U.S. Treasury Department and the U.S. Federal Reserve were the driving force behind those profits. Investment banks like Goldman weren’t just given a level playing field – they were given one that was essentially (and artificially) cleared of obstacles. Even the few “competitors” that remained were hobbled by their past mismanagement.

Investment banking is not particularly difficult or intellectually challenging. And the proliferation of new and complex products that turbocharged the profit growth of investment banks during the past few decades won’t continue. Any new financial product will be forced to run a gauntlet of regulatory bureaucrats before being allowed to emerge.

Had the credit-default swap (CDS) been invented today, can anyone doubt that it would have been fenced in by restrictions so onerous that the damaging derivative would have never made it to market? The painful memories of last year’s near-unraveling of the global financial markets are still fresh. So it’s unlikely that investment banks would be able to get the regulatory nod for a big-risk strategy that is likely to result in a taxpayer bailout.

The bottom line is clear: The reduction in U.S. investment banking profitability is likely to be permanent, with various rent-seeking scams blocked. In this post-crisis era, investment pools from China, the Middle East and other parts of Asia – backed by increasingly sophisticated financial players in those markets – will acquire the necessary capabilities to enter the market and further reduce the returns of domestic investment banks.

We have seen this before: An industry, previously very profitable, finds itself hemmed in by government restrictions and its most-profitable products get regulated out of existence. Foreign competition enters the market and grinds away at the domestic market share.

The natural reduction of competitors doesn’t happen, as one or more are bailed out by taxpayers and survive to continue competing for the business.  Legacy costs of remuneration promises made when things were better place an ever-increasing burden on the industry’s returns. Reducing the work force pay becomes very difficult, as the workers have great power over production and resist the necessary downsizing of their excessive pay.

Sound familiar? Last time, it was the U.S. auto industry, and the eventual result was the bankruptcy of GM and Chrysler. Reducing pay to a work force when market conditions become harsh is extremely difficult, if now downright impossible.

Of course, investment bankers have no United Automobile Workers (UAW) representing them. But shareholders will know from past experience that the investment-banking work force’s ability to suck up available profits is huge, whereas losses suddenly devolve back on shareholders.

Don’t forget, militant autoworkers could only beat up “scabs” when their livelihood was threatened. Militant traders could re-jig the computer systems so that the trading algorithms worked backwards, producing losses instead of profits. In an era of credit default swaps and millisecond trading, this could wipe out shareholders in half an hour of frantic activity before anyone realized what had gone wrong in an era of credit default swaps and millisecond trading.

It may take a couple of decades for the investment banking business to decline, as it did for the much larger U.S. auto industry. But by 2030, collapse could loom.

The comparison isn’t a stretch. In fact, it wasn’t just a ticker-symbol letter – “G” – that  the two companies shared: GS for Goldman Sachs, and GM when General Motors was still a public company. It turns out that their underlying business models also shared similar strategic flaws. And those flaws put the two on a similar path to ruin at the hands of forces that grew out of the crises in their particular industries – crises that they each helped create.

Source: Could Goldman Sachs Share GM’s Fate?

I think that’s wrong. It’s an erroneous viewpoint that’s symptomatic of the short memories of the chattering media. It’s also one that could cause investors to miss out on one of the best profit plays in the global marketplace today.

I’m talking about Germany – the real powerhouse of Europe.

The “New” Germany

From the 1950s to the 1980s, West Germany consistently delivered high growth rates and low inflation. West German engineering proved superior to any other on the planet. And West German living standards rose far above anywhere else in Europe.

Then came 1990.

East and West Germany were reunited and an economic malaise set in. Instead of unifying the two currencies at a ratio of two Ostmarks to one Deutsche Mark, which would have kept East German labor cheap and competitive, the politicians unified the currencies at a rate of one to one.

That meant that East German labor was instantly priced out of the world market. And with good reason: It now offered Soviet-sector efficiency and skill – but at West German costs levels. Consequently, East Germany went through more than a decade of very high unemployment. German taxpayers went through more than a decade of huge subsidies to the former East Germany to prop up that region’s living standards and retrain its labor.

However, since the excellent German high school education system was quickly established throughout the country, the burden of reunification was a problem that did not last forever. What ultimately happened was that younger, fully trained workers in East Germany replaced their inferior Communist-era parents.

From about 2005 onward, the financial cloud of reunification costs began to lift. During the last few years, Germany’s economic performance has been notably better than its European competitors. Against Italy alone, for example, Germany’s competitiveness has improved by more than 20% since Europe’s currencies were unified in 1999.

The German economy has been held down by a tax burden that’s high by global standards. Its tax system suffers from excessive complexity and from draconian enforcement. Small businesses, for example must pay a 14% trade tax – on top of the standard corporate income tax that all businesses must pay. The trade tax goes to the “lander” (the states), rather than to the federal government.

Despite such problems, Germany has played it smart in several key areas. Unlike the United States and many other countries, Germany did not engage in fiscal stimulus. Indeed, the Social Democrat Finance Minister Peer Steinbruck last winter referred to Britain’s huge fiscal stimulus plans as “crass Keynesianism.” That showed that Germany has a true consensus against the stimulus foolishness. Germany’s budget deficit is expected by The Economist panel of forecasters to be only 4.6% of gross domestic product (GDP) in 2009, far below its rich-country competitors. Thus, even though Germany’s taxes are high, they will not be forced further upwards by zooming budget deficits.

The Angela Merkel Era Begins

Merkel’s election as German Chancellor is important, because it enables her to govern in coalition with the most free-market party, the Free Democrats, who are committed to lowering taxes and freeing up some of Germany’s restrictive labor laws.

This should not be taken too far. The Free Democrat leader Guido Westerwelle, flushed with victory, pledged Sunday night that the new government would act “responsibly” – not exactly “Hope and Change” as a slogan! Nevertheless, the Frankfurt market rose on the election result, as it should have done.

Germany is sometimes knocked for its export orientation. Its balance-of-payments surplus was $179.4 billion for the fiscal year that ended June 30, and is expected to be 4.0% of GDP this year.

Rest assured, however, that this is strength, and not a weakness. With world trade recovering, the German economy can be expected to benefit. Just look at Germany’s auto sector, which may be the most well rounded in the world. It boasts such strong luxury brands as Mercedes (NYSE ADR: DAI), Porsche and Audi. And it includes such high-volume – but innovative – manufacturers as Volkswagen AG (OTC ADR: VLKAY). German automakers are likely to gain market share against faltering U.S. competitors in the coming global recovery.

Another plus: Germany’s savings rate rose to 12.8% of GDP in the first half of 2009, a 16-year record. That compares with the feeble rate of only 4% in the United States, up from close to zero in the preceding three years. In a competitive world with the financial sector in difficulty, it’s better to be a capital-rich country running a trade surplus than the opposite, like the United States.

The economic recovery is a mixed bag from one market to another. But in Germany, it seems in Germany to be proceeding briskly. GDP, which fell sharply in the first quarter, rose at a 1.3% annual rate in the second quarter. Manufacturing orders rose by 3.5% in July, after a 3.8% rise in June. The ZEW index of economic sentiment has risen in each of the last six months, reaching a healthy 57.7 (50 is neutral) in September.

With competitive manufacturing, a business-friendly government and plenty of domestic capital, Germany is about as healthy an economy as there is in the world today. You should think about staking a claim to this outlook, even if it’s only the MSCI Germany Exchange-Traded Fund (NYSE: EWG).

Source: Why You Should Invest in the ‘New’ Germany

That means interest rates will remain at artificially low levels for some time to come.

And it also means the central bank’s policymaking arm, the Federal Open Market Committee (FOMC), has finally and firmly cemented its role as the Keynesian death panel for the savers of America.

The malign influence of the late economist John Maynard Keynes is nowhere more destructive than it is in the area of saving. After all, it was Keynes who proclaimed that his ideal economy would see “the euthanasia of the rentier” – an abolishment of the class of people who live off of income from savings.

We know that Keynes’ theories are still rampant in choosing U.S. fiscal policy, which has given us the largest peacetime budget deficit in history. Wednesday’s statement by the central bank’s policymaking Federal Open Market Committee (FOMC) shows that the monetary sector is enthralled by Keynes’ destructive views. As savers and investors, it’s about time we got a voice in this. After all, it’s entirely possible that we don’t want to be killed – not even mercifully – by the FOMC’s zero interest-rate policy and its erosion of our savings.

The current economic situation has the United States in an embryonic – but unmistakeable – recovery. Commodities prices are soaring and the U.S. stocks, as measured by the Standard & Poor’s 500 Index, are up 55% from their March 9 low.

If you were setting monetary policy for such a country, you’d surely make it only moderately stimulative, because the dangers of soaring commodities prices and what looks very much like a stock market bubble are considerable. With the “core” consumer price index (CPI) having risen 1.4% in the last 12 months, that would suggest a Federal Funds target of somewhere in the 2%-3% range. That would constitute a “real” short-term interest rate of 0.6%-1.6%, just below the neutral level of about 2%.

Needless to say, the Fed has a problem.

A No-Win Proposition for Savers

If it moved interest rates back to the appropriate rate quickly, it would cause a huge market panic: A move of 2% or more in the Federal Funds target would hit hard at the market’s confidence.

However, it could begin moving in that direction, perhaps by raising the target by a quarter percentage point – which would take it to a range of 0.25%-0.50%. That would not tighten policy much, but would indicate the Fed’s intention to tighten it in the future.

The market reaction would be considerable; if it knew higher interest rates were coming, the stock market would slow its ascent and commodity prices would stop soaring. The latter would be very good news, indeed, for the U.S. economy and for U.S. consumers generally.

By taking the opposite view, and nailing itself to the zero interest rate policy, the Fed has made it very difficult to raise interest rates when it needs to, which will be pretty soon.  However, there’s another effect – this one affecting savers – which will do even more long-term damage.

Commentators have for years been bemoaning the low U.S. savings rate, pointing out that it causes the U.S. balance-of-payments deficits, making us beholden to China, the Middle East and other places that may or may not be our friends. However, my question is, why the hell should anybody save if they don’t get paid to do so?

In this environment, savers get ripped off in three ways:

• First, they get almost nothing on their savings, except by taking lots of risk.

• Second, the value of their savings gets eaten away by inflation. That’s only 1.4% currently at the “core” level, which purposely excludes more-volatile food-and-energy prices (more on that in a moment). And that’s only if you believe the “official” figures, which I don’t entirely – they’ve been tweaked much too often. However, the rise in commodity prices, the weakness in the U.S. dollar and the beginnings of economic recovery suggest that inflation will be considerably higher in the months ahead. And that’s even if you don’t include the “volatile” food-and-energy prices, as the government doesn’t (Though it should: Real people can’t live their lives without consuming food and energy, and thusly suffer from “real” – and not “core” – inflation).

• Third, after they’re received very little on their money and had their money eaten away by inflation at rate that exceeds their savings return, those savers still have to pay income tax on interest and dividends, even when those returns don’t make up for the inflationary erosion of capital.

The Fed has been running a monetary policy that rips off savers since 1995. That means that the central bank has spent the last 14 years pushing up the money supply at a rate that greatly exceeds nominal gross domestic product (GDP).

So it’s not at all surprising that people don’t save much; they’re being paid not to do so. The Fed’s policy is very convenient for all those who borrow money – from the big banks and investment banks to the homeowners who took out too large a mortgage and can’t service it.

In other words, it’s become a very one-sided game.

Three Strategies for Savers

As savers, we can take several steps. We can agitate, like the “tea party” protesters. It’s about time U.S. Federal Reserve Chairman Ben S. Bernanke stopped basking in his approval by all the Keynesians and felt the anger of real people, whose savings he is destroying.

Apart from that, we can invest in a way that gets around Bernanke’s machinations. Three moves in particular make a lot of sense:

• First, we should save as much as possible tax-free, since the tax system discriminates against us. So max out IRA contributions, education funds, and any other investments that shield part of your holdings from the taxman’s bite.

• Second, we can put our money outside Bernanke’s reach – in foreign markets. The European Central Bank (ECB) at least mildly cares about savers, and has pursued a more careful policy than the Fed. Within the EU, Germany is recovering nicely, partly because it had very little fiscal stimulus, and has almost no inflation. Outside the EU, Japan and Korea are both recovering nicely, and so are worth looking at, as their policies are at least independent. (Japan, under the previous government, had a Bernanke-like determination to ignore the needs of its savers. But that may have changed under the new government).

• Finally, we savers can engage in the ultimate Bernanke protest, and buy gold, silver or the shares of mining companies. Once the Fed reverses its policy, these will be rotten investments. But it’s pretty clear that the Fed is not going to give savers an even deal soon. In that case, if the Fed doesn’t reward us, gold and silver will. The dollar will decline, and gold and silver prices will rise, until eventually the Fed is forced to act. But my bet is the Fed will move very slowly, so we’ll get plenty of warning.

We savers have rights, too. And we also have money.

It’s about time we invested it where its enemies can’t erode it.

Source: The New ‘Death Panel’ for Savers

And with good reason. The United States has a bigger and more-troubled financial sector than most countries. It also has a bigger overhang from the housing bubble, has a bigger balance-of-payments deficit and has a budget deficit that’s fat enough to stall the recovery.

It would be nice to have an economic recovery to invest in that didn’t have all of these problems.

Truth be told, such an investment play does exist. What’s more, the market I have in mind is advanced enough for us to invest in it without having to go through all the rigmarole of American Depository Receipt (ADR) investing. Nor will you have to make a potentially risky foray out onto some foreign stock exchange to buy the shares, because they are almost all listed here.

The country I’m talking about is Canada. Think of it as being like home – but without the problems that our home market (the United States) currently suffers from.

Our Healthy Neighbor to the North

When the recession struck, Canada was hit by it quite badly, but for different reasons from its southern neighbor. The Canadian housing market was nowhere near as overheated as its U.S. counterpart. So Canada’s housing downturn wasn’t as deep.

And what about the banking systems? To be sure, Canadian banks received a bailout, but it was less than $20 billion in total. Compare that to the veritable alphabet soup of U.S. bailout programs ranging from “TARP” and “TALF” that have injected more than $2 trillion into the U.S. financial system.

On the other hand, natural resources prices crashed last autumn, which had a major effect on Canada’s resource-based economy. A number of large projects in the Athabasca Tar Sands region were cancelled, for example – since this region has oil reserves around the size of the entire Middle East, its development is crucial to Canada’s future.

The “loonie,” Canada’s currency, declined from around “parity” to the U.S. dollar to an exchange ratio of C$1.30=$1 U.S. In effect, this was a “flight to safety” into the dollar and U.S. Treasuries. And it affected Canada as it did other countries.

In 2009, however, Canada and the United States have traveled down totally different paths. Canada did very little “stimulus,” so its state budget is in much better shape. The deficit for the 2009-2010 fiscal year $53 billion (C$56 billion) is only about 4% of gross domestic product (GDP). For the 2010-2011 fiscal year, the deficit is expected to be about $42 billion (C$45 billion), or 3.2% of GDP.

Energy Powers the Rally

The bounce in natural resources prices has really helped power up the rebound of Canada’s market.

Investment in the tar-sands region has picked up again, with a big merger between the two largest tar-sands-extraction companies: Suncor Energy Inc. (NYSE: SU) and Petro-Canada. The rising gold price hasn’t hurt either – mines are appearing all over the place! All this new activity has made the loonie bounce, so it’s back to about C$1.07=$1. While interest rates are as low as the United States, the Bank of Canada hasn’t done much “quantitative easing,” meaning that inflation isn’t too much of a worry.

The strong loonie helps here, too.

Canada seems to be recovering nicely. Its index of leading indicators jumped 1.1% in August, while manufacturing sales grew 5.5% in July. The country presently runs a modest current account deficit, but it’s only 2% of GDP. That’s much lower than even the current U.S. deficit, let alone that of 2007. It had a little more public debt than the United States in 2008, but given current U.S. deficits, those two lines almost certainly have crossed by now.

There are two caveats. The first is an obvious one: If commodity prices crash to earth, Canada will have some difficulty because commodities are a large part of its economy. Personally, I don’t see that happening. It’s notable that PetroChina Co. Ltd. (NYSE ADR: PTR) has just invested $1.7 billion in a Canadian tar sands project, so China must not think so, either.

The other risk is political. The current minority Conservative government of Stephen Harper has done a good job, but the opposition Liberals have withdrawn their parliamentary support. That means there may be an election this autumn. A Liberal majority government would be no disaster. They might be a bit sticky about oil-drilling permits, but would not otherwise rock the boat.

However, a Liberal coalition with the leftist New Democrats could push public spending and the deficit up, and there’s no guarantee against that. (One of the problems with multi-party systems like Canada’s is there is an almost infinite variety of possible governments after each election, some of which can be fairly alarming from a business perspective.)

However, Canadian elections are a much smaller risk than you get in most countries, and the commodity/oil price crash, if it happened, would help the U.S. economy and, presumably, your U.S. portfolio. So it’s worth having some Canadian exposure, perhaps with the Canadian market exchange traded fund (ETF) iShare MSCI Canada Index (NYSE: EWC).

For years it was almost fashionable to dismiss Canada from an economic standpoint. Now, however, that may well be where the smart money would like to go. As an economy, Canada is competent and stable.

It’s the kind of country that looks to be a good place for some of our money.

The Standard & Poor’s 500 Index is up 58% from its March lows, gold has finally broken through the $1,000-an-ounce level – and may go higher – and bond yields have fallen substantially in spite of the huge U.S. budget deficit.

It’s really not difficult to tell when you’re in a bubble. What’s tough is trying to figure out how to invest while it’s developing.

When current Fed Chairman Ben S. Bernanke doubled the monetary base in a few weeks last fall, it was pretty obvious that the extra money would appear somewhere, either as zooming asset prices or as surging inflation. After all, the rapid increases in the U.S. money supply after 1995 produced a stock-market bubble and then a housing bubble.

And don’t forget about interest rates. When oil prices doubled in less than 12 months between 2007 and 2008, it was because Bernanke aggressively cut interest rates after the recession first hit in late 2007. So you’d have to believe that money supply was irrelevant not to expect markets to start behaving oddly at some point.

Silver and Gold …

That’s why – since late in 2007– I have been recommending investments in gold and other hard assets. While the recession had sharply reduced demand for oil, causing its price to drop from its record high of $147 a barrel in July 2008 to around $30 in February, the gold price had dropped only from its March 2008 peak of $1,000 to around $700, before rebounding. Gold prices remain far below the inflation-adjusted equivalent of their 1980 peak, which would be around $2,300 per ounce today.

Likewise, silver prices are even further below their 1980 peak, which would be around $130 per pounce, or nearly 10 times the current level. Since both gold and silver markets are relatively thin compared to the money available – annual gold production is only $100 billion at current prices – the potential for a run-up is considerable.

The difference between a bubble and a sound bull market is that a bubble happens more quickly. Normal valuation metrics get ignored. You couldn’t rationally justify – on any sort of long-term basis – the dot-com stock prices of 1999, the California house prices of 2005, or the $147-per-barrel record oil prices of 2008.

Similarly, today’s cost of extracting gold is nowhere near $1,000 an ounce. Mining costs have increased. But extraction costs are still only about $400 an ounce for top-tier miners.

Likewise, with inflation at 2% and U.S. budget deficits at more than $1 trillion per annum, there’s no justification for a 10-year U.S. Treasury bond yield below 3.5%.

Let’s look at stocks. And let’s say that the market of early 1995 – when the Dow Jones Industrial Average was at 4,000 – is a reasonable base for estimating a fair value for the U.S. stock market. If that were the case, then inflating the Dow in line with nominal gross domestic product to keep it at fair value would bring us to a current day estimate of 7,800.

[The Dow closed yesterday (Thursday) at 9,783.92. To reach this “fair-value” level, the Dow would have to drop 1,984 points, or 20% – enough of a decline to qualify as an official “bear market.”]

However 1995 wasn’t a bear market, and economic and earnings prospects that year were really good. Besides, the Internet was just starting its rise to prominence. Today, we’re in a deep recession, with huge budget deficits and high unemployment, yet the Dow is closing in on 10,000.

In other words, U.S. stocks are overvalued. Even after the bearish trauma of last year, we remain in a stock-market bubble.

Four “Bubble” Investing Strategies – Including the One That Works

Bubble investing is different from bull-market investing. There aren’t many “good” values, so you have to be very careful.

One bubble-market strategy is to just put everything in cash and hide under the bed. How boring! Plus, as your neighbors brag about their profits at cocktail parties, you’ll feel like an idiot until the bubble bursts. Remember, even after your neighbors’ profits have turned to losses and you look smart, you can never get those cocktail parties back!

That doesn’t mean you should abandon prudence, however. You should certainly keep much higher cash reserves than normal. Indeed, consider investing a chunk of that cash in one of the non-dollar-denominated WorldCurrency Access Deposit Accounts offered by EverBank.

At the same time, it’s a pity to completely miss out on the returns one can earn in a bubble environment. But you have to careful and smart.

A second bubble-investing strategy is to find something that isn’t overvalued, and buy only that. That strategy worked great for me back in 1999. I was working in Croatia, which was going through a deep economic crisis. NATO was bombing neighboring countries in the Kosovo War. That played merry hell with tourism, Croatia’s main foreign currency earner. Croatian shares – there were about six at the time – were each selling at less than five times earnings. So I invested in Croatia and made out nicely when the war ended and things returned to normal.

The problem with that approach is globalization. It was just possible in 1999 to find undervalued investments, if only by putting your money close to a war zone. It isn’t really possible now, at least not to any great extent. Three months ago, there were lots of shares even in the United States, which had been bombed out by the downturn and hadn’t recovered. There aren’t many left now; if a share is bombed out today there’s probably good reason for it.

A third potential strategy is to try to time the bursting of the bubble. For example, you could buy the ProShares UltraShort Trust (NYSE: TBT), inversely related to twice the Lehman Brothers Holdings Inc. (OTC: LEHMQ) 20-year bond index. Then you’d wait for the bond market to crash, and TBT to soar.

But there are two problems:

• First, the ProShares UltraShort Trust has a fair-sized tracking error, because they have to rebalance the fund daily. Thus if you hold it too long, you won’t do as well as you should.
• Second, the bubble can take a long time to burst; meanwhile it goes on inflating and you get killed. In the long run, it was a good idea to short Cisco Systems Inc. (Nasdaq: CSCO) in 1999. In the short run, it wasn’t so clever.

The Winning Play

The normal investment approach, to buy only the most conservative companies in an overvalued but bubbly sector, also doesn’t work. Everybody else is looking for them, too. And that means they end up being overvalued. Besides, they will advance only modestly with the inflating bubble, so you won’t make enough to compensate for the risk of buying too high.

The best alternative, therefore, is to buy bubbly investments – but the junk, not the cream. Buy gold and silver mines that even at $900 an ounce have only been running at close to break-even, because they have expensive deposits.

Don’t buy political risk (i.e. mines in dodgy countries), because if the gold price goes up, the local dictator will seize your company’s winnings. But operating risk is okay. And high operating costs are fine. If your mine has operating costs of $800 an ounce, you’ll make out like a bandits if gold goes from $1,000 an ounce to $1,200. That way, you need only put a modest amount in the investment, and it will zoom up to several times what you paid, making as much profit as if you’d put your entire fortune in something conservative.

Make sure to put only a portion of your money in such a play. Keep the rest in cash.

When to sell? Well, start selling at the first signs that the Fed is beginning to take inflation seriously, meaning the central bank will be pushing up interest rates. You’ll know when this is because you’ll likely start hearing a lot about Fed “exit strategies.”

Don’t be greedy – better to sell too early than too late. Better to leave the theater at the first wisp of smoke, than to wait until the entire crowd is panicking and heading for the exits.

I hate bubbles. And I hate Bernanke and the other central bankers for causing them by their misguided monetary policies. But you can make money out of them. Just don’t get carried away.

Source: The Only Way to Profit from a Stock Market Bubble

Brazil had clearly become the new “must-play” market for investors.

And then they had to go and spoil it all.

As promising a market as Brazil had become, it was the discovery of the massive Tupi oil field off of the country’s east coast – that really transformed Brazil into an investor’s dream. The oil and natural-gas reserves are located beneath heavy salt beds in deep offshore water. These reserves are 23,000 feet to 26,000 feet down, a depth that wasn’t even accessible until recently.

These Tupi reserves appear to contain at least 60 billion barrels of oil, worth $4 trillion at today’s prices. Tupi oil is expected to start hitting the market in 2011 or 2012. When that happens, it will revolutionize Brazil’s economy and its shift its balance of payments.

The exploration of the Tupi oil fields had been carried out by the Brazilian oil company Petroleo Brasileiro SA (NYSE ADR: PBR) – more commonly referred to as Petrobras – in partnership with some of the international majors. The contracts call for the Brazilian government to receive royalties on any oil found.

Brazil is now one of only three top oil-producing countries to not assert state ownership of its oil reserves. Canada and the United States are the others.

This was very reassuring for the international oil majors. They’re used to dealing with fruitcake kleptocratic regimes in Venezuela, Angola, Nigeria and most of the Middle East. As a result, the Tupi deposits generated real excitement both among oil companies and among international investors in general. The feeling was that Brazil was about to end its two centuries of failed economic hopes. Fueled by oil revenue and additional economic activity, Brazil appeared ready to claim its true destiny as a wealthy country.

Unfortunately, it wasn’t to be.

Although there are several reasons for this, a key culprit is the election scheduled for next year. Incumbent Brazilian President Luis Inacio “Lula” da Silva can’t run again. But he’d very much like to choose his successor. The most likely candidate: current Chief of Staff Dilma Rousseff.

Rousseff was put in charge of devising a scheme to capture more of the Tupi oil revenues for the Brazilian government and, nominally, the Brazilian people. Tales were spun of how the new revenue would finally eliminate Brazilian inequality, and bring its poorest citizens up to Western living standards.

The new system announced this month reflects this aspiration. A new state oil company, Petrosal, would be created to manage the reserves. Petrobras – aided by outside investor capital – would carry out production. And Petrosal and the outside investors would share the output.

This plan will imbue Petrosal with a lot of power. The company would control half the votes on the operating consortium. And it would have veto rights over production and capital expenditures.

The revenue would be managed by a new state fund. The fund would devote this new cash to poverty relief, education and infrastructure.

In the meantime, the existing royalty system would remain in place. Under this system, outside investors would pay both royalties and a production share. In one acknowledgement of marketplace realities, concessions already granted would not be torn up.

There are two major problems with this system. First, it makes life much more difficult and less profitable for oil companies wanting to invest in the Tupi oil field. Had Brazil torn up existing contracts, I believe the oil majors would have left. In the past two years, the world’s Big Oil firms already saw existing agreements torn up in Nigeria and Venezuela. There’s just no point investing large amounts of money under such risky conditions.

As it is, the new Brazil agreement applies only to new contracts. So I believe the oil companies will probably put up with this new system – at least as long as oil prices remain high. It’s not as if these firms have a lot of alternatives right now.

However, given how expensive it will be to extract this oil, if market prices drop, it may end up being difficult to attract Big Oil players.

The more dangerous problem is this fund, which is little more than a huge pool of money that politicians can play with.

As I mentioned, Brazil’s economy has been one of the world’s best performers. This year, in the face of a worldwide recession, Brazil’s gross domestic product (GDP) is expected to decline only 1%, according to the forecasting panel of The Economist magazine.

Inflation is 5% and the budget deficit is only 2.8% of GDP – both excellent figures in this difficult year. Brazil’s monetary policy is an example to the world, with short-term interest rates still at 8.65%, well above the inflation rate.

But this money pool plan puts that performance at risk.

Brazilian public spending is already 35% of GDP, very high for such a poor country. State bureaucrats have feather-bedded contracts guaranteed to them under the 1988 constitution. So this “slush fund” will just fuel Brazilian corruption, diverting still more of that country’s economy into the pockets of politicians, their friends and favoured interest groups.

It’s no use for Brazilian spin-doctors to point out that Norway and Alaska have funds of this nature. Norway and Alaska have small populations and relatively un-corrupt political cultures. This fund must inevitably represent at least 3%-5% of Brazilian GDP. And it will be mostly wasted, spent without the market having any say as to its use or destination.

I’ve been watching Brazil for more than 30 years; since I began travelling there for the merchant bank Hill Samuel [now part of Lloyd's Banking Group PLC (NYSE ADR: LYG)] in the late 1970s. It’s a maddening country: Just when you think the Brazilian authorities have finally got their act together, and that the country is ready to achieve the enormous economic growth predicted for it since at least 1900, something unexpected and foolish goes wrong.

This appears to have happened again. And that’s a real pity – for Brazil’s citizens, and for global investors.

Source: The World’s Most Exciting Market – Until They Spoiled it

With this recent rush of upbeat economic news, it’s no wonder commentators are trumpeting the rebound of the U.S. economy.

But I think it’s time to short U.S. stocks.

Shocked?

Don’t be.

What most experts see as a strengthening U.S. rebound, I see as an increasingly dangerous “false dawn” – for these two key reasons:

• An overly expansive monetary policy that’s almost certain to spawn inflation.
• And a record-level budget deficit that will cause interest rates to spike, crimping economic growth.

A Foundation for Trouble

U.S. policies that were intended to combat the financial crisis that broke last year – as well as the recession that’s been plaguing us since December 2007 – have actually inflicted a lot of weakness upon our economic system.

For instance, the federal government has made $11.6 trillion in financing commitments, many of which will saddle us with debt for generations – some of it forever. Outlays of that magnitude in a $14 trillion economy are bound to have lasting implications: Think of the consumer who has a series of maxxed-out credit cards – he’ll make the minimum payments, but the actual balance will never get paid down.

And the foundation for this financial fiasco was actually constructed several years ago.

After the bursting of the 1996-2000 “dot-com” bubble, the U.S. Federal Reserve re-inflated the money supply. That caused stocks to resume their upward march, and as we now know, also inflated a housing bubble of such enormous size that it caused a general financial-system crash when that real estate bubble burst in 2007-08.

This time around, the Fed has been even more expansive. The benchmark Federal Funds Rate was 1.0% in 2002-04. This time it is 0.25%. What’s more, this time around we’ve had a $2 trillion expansion of the Fed balance sheet, a doubling of the monetary base and $300 billion worth of direct central bank purchases of government debt. Given this orgy of Fed expansionism, it’s likely that the onset of inflation – whether it’s in consumer prices or asset prices – will be correspondingly worse. In fact, we’re already seeing that gold prices are once again making a run at their all-time high. And crude oil hovers at about $70 per barrel, a level that would have been unimaginable before 2004.

Now that he’s been nominated for reappointment, U.S. Federal Reserve Chairman Ben S. Bernanke says he will tighten monetary policy in good time. But why should we believe him? If he tries to tighten significantly, he will incur the wrath of the Obama administration and the Democrats in Congress.

Even back during the 2001-04 time frame – when there was an administration in place that claimed to believe in monetary stringency – the Fed didn’t tighten. Bernanke himself was among the most aggressive opponents of tightening. Back in 2002, in fact, when inflation was running at a perfectly respectable 2%, Bernanke actually spun myths about the imminent onset of “deflation.”

Given what we know, it seems that if the current economic bounce shows even the slightest signs of faltering, Bernanke won’t tighten – he’ll pump even more money into the U.S. financial system. Rest assured that the administration, Congress, and much of the media will be cheering his move.

Borrow Now, Hurt Later

If an overly expansive monetary policy was the only problem we faced, it might not be so bad. Unfortunately, there’s more.

Lots more.

Unlike in 2002 – in fact, unlike any other time in U.S. history – this country now has a budget deficit in excess of 10% of gross domestic product (GDP). For fiscal 2009, that was forgivable: We’ve had a major recession, and a shattering financial crisis, which the federal government has tried to battle with aggressive bailout programs.

Here’s the problem, however: The projected deficit remains above 10% of GDP for fiscal 2010, even though no additional bailouts are contemplated and the Obama administration is projecting a modest-but-steady economic recovery.

The result is harder to predict – this country hasn’t travelled down this particular path before. This strategy bears some resemblance to the position Japan found itself in during its so-called “Lost Decade” of the 1990s. But even Japan’s deficit never reached this 10% threshold.

In Japan, the effect seems to have been the gradual abandonment of small business finance, and the resulting starvation of the most critical factor in economic growth – entrepreneurship.

The small-business sector creates most of the new jobs in the U.S. economy. But in a challenging environment, it’s easy to see why this sector gets overlooked. Without political connections or large contracts to hand out, the small-business sector ends up being last in line in the financing queue when the economy faces strong headwinds. Why should banks or other people lend to small businesses when the U.S. government bond market stands as such as huge, safe parking place for their cash?

Interest rates will also become an issue. With the inflationary pressures we expect to see from the overly expansive monetary policy we’ve described, long-term interest rates are likely going to rise anyway. As was the case in Japan’s decade-long malaise, these forces will combine to spark high default rates in the banking system, low or zero economic growth, and a general downward trend in the stock market.

All of this will make it tough for small businesses to obtain the cash they need to grow, meaning this key job-creation engine will have to sputter along.

It’s still early in the game, and there are many factors to consider, so the future economic picture remains a bit murky right now. But my guess is that the bubble in asset prices will be largely confined to commodities, that economic growth after this current initial burst will relapse, and that U.S. stocks will prove to be the same generally unattractive investment that they were in 1970s – the era of the so-called “Nifty Fifty.” If the stock market bubble gets even more exuberant from here, the relapse will be correspondingly more painful.

Profitable Pockets

Despite this dour backdrop, three things are worth remembering:

• First, all U.S. stocks are not created equal. Although I’m saying it’s time to short U.S. stocks, and I see tough times ahead for the key indices, there will always be individual stocks worth consideration, such as the “Alpha Bulldog” stocks I highlight in the Permanent Wealth Investor service.
• Second, the best way to play this looming downdraft – either as a direct profit opportunity or as a way of hedging your current portfolio – is through the use of what I like to call “Stage 3″ investments. An example of one such investment is long-dated “put” options on the Standard & Poor’s 500 Index, which trade on the Chicago Board Options Exchange. If you buy these options when they are way “out of the money” with a strike price far below the current price, in a real bear market (like that of 2007-09), you will see them really zoom up in value as the S&P drops down closer to the strike price, or possibly even falls below it.
• And third, understand that my pessimism about the U.S. market doesn’t apply to every other market around the world. While the monetary problems are more or less global, the budget-deficit problems are not. For instance, you might want to consider investments in Japan, where a recent election should spawn the kind of economic changes that will benefit savvy investors. Germany, too, looks to have avoided the contagion of “stimulitus,” which is why its economy is now viewed as one of the healthiest in Europe. Consider the iShares exchange-traded fund (ETF) entry for each of those two markets: The iShares MSCI Japan Index Fund (NYSE: EWJ) and the iShares MSCI Germany Index Fund (NYSE: EWG). They each warrant a look.

Source: The Two Reasons it’s Time to Short U.S. Stocks